Financial or commodities instruments may be traded in government regulated exchanges and cleared through regulated clearing monopolies such as the National Securities Clearing Corporation (NSCC) (for equities), the Options Clearing Corporation (OCC) (for equity options), or the Government Securities Clearing Corporation (GSCC) (for treasury bonds). In contrast, instruments for which no central clearing solution exists are traded “OTC” or “Over the counter.” OTC products are traded and settled through multiple independent venues, introducing settlement risk and therefore affecting the marketability of prices as a function of the credit worthiness of the participants. Because settlement risk varies by participant, different participants have access to different rates in an OTC market. For example, most debt instruments are traded OTC with investment banks that make markets in specific issues. If a customer wants to buy or sell a bond, he or she will contact the bank that makes a market in that bond and ask for quotes. Many instruments, including forwards, swaps, currencies, and other types of derivatives are also traded OTC. In these OTC markets, large financial institutions typically serve as dealers, i.e., market makers. In an OTC market, a fair price is typically defined by what a willing buyer will pay and what a willing seller will accept.
A market maker typically provides a pair of prices to its customers, i.e., bid and offer prices. The bid price is the price the market maker is willing to buy from a customer, whereas the offer price is the price the market maker is willing to sell to a customer. The bid price is typically lower than the offer price, providing a spread, i.e., profit for the market maker.
In an OTC market, a market maker may trade instruments traditionally, e.g., by phone, or electronically, e.g., using a service provider. A service provider, such as Currenex (www.currenex.com) or EBS (www.ebs.com), typically provides one or more electronic communications networks (ECN), i.e., trading exchange platforms, for market makers to trade instruments electronically in an OTC market. A market maker may deal in multiple platforms. Likewise, a service provider may support multiple market makers through multiple liquidity pools (also referred to as exchange platforms, exchanges, exchange markets).
In addition to market makers, there are intermediaries called brokers that often aggregate liquidity from several liquidity sources. Many brokers have their own customers and act as a counterparty for both their customers and their liquidity sources. For these brokers each transaction results in two trades; one with their customer; the other with their liquidity source. Because brokers typically have access to multiple liquidity sources, they have superior pools of liquidity to draw upon for generating prices to their customers, enabling some brokers to mark up the price they receive from their liquidity sources, resulting in a profit when they deal with their customers.
Current service providers do not offer intelligent methods of defining and applying an optimal spread for market makers and brokers. When a preferred spread is two pips, for example, and an input rate offered by a market maker is 49/50, currently service providers will simply add one pip to each side, i.e., the bid price and offer price (e.g., 48/51). A pip is typically the minimum fluctuation or smallest increment of price movement. No intelligent method is offered to maximize profits for market makers and brokers.